Finance for NonFinancial Managers Fifth Edition

1
Finance for Non-Financial ManagersFifth Edition

• Slides prepared by
• Pierre G. Bergeron
• University of Ottawa

2
Capital Budgeting
Chapter Objectives

• Explain the capital budgeting process.
• Comment on the key elements used to gauge capital
  projects.
• Evaluate capital investment decisions by using
  time-value-of-money yardsticks.
• Assess capital investments using decision-making
  techniques that measure risk.
• Explain the reasons that can prevent a capital
  project from being approved.

Chapter Reference Chapter 11 Capital Budgeting
3
Why Capital Projects are Important
Capital investments
Expense investments
Large Durable Capitalized Recurrent and spread
over many years Significant Minimal to sizeable
Small Impermanent Expensed One time and
immediate Minimal None
Size of the cash outlay Nature of
commitment Accounting treatment Cash
turnover Financial impact of
commitment Effect on financial structure
4
Compulsory and Opportunity Investments
Opportunity investments
Compulsory investments
Effects Response Benefits Risk Management
involvement Implications Analytical techniques
Maintain operating efficiencies To a
need Immediate Negligible Low-level Legislative,
employee safety and satisfaction Simple
calculation
Increase momentum of the firm To an
opportunity Long-term High Top-level Economic
returns, share of market Mathematical models
5
1. Capital Budgeting Process
Step 1
Environmental
Step 2
Step 6
Formulation of plans and capital expenditure
projects
Corporate priorities Strategic goals
Operational goals
Project approval and implementation
Scanning
Step 3
Step 4
Step 5
Capital expenditure ranking on basis of
priorities/goals operations/functions
return/risk
Cost of capital internal financing external
financing
Determining the hurdle rate
6
2. Key Elements Used to Gauge Capital Projects
Cash Outflow
Capital assets Working capital Normal
capital additions
Net income Non-cash expenses Residual value
Cash Inflow
Economic life of project
Sunk costs
7
3. Evaluating a Capital Expenditure Project
Assumptions 1. A 1.5 million investment to
modernize a plant. 2. The economic life of the
project is 10 years. 3. The annual savings are
300,000. 4. The cost of capital is 14.
Year Outflow Inflows Discount
factors Present value 0 1,500,000
--- --- -1,500,000 1 --
300,000 0.87719 263,157 2 --
300,000 0.76947 230,841 3 --
300,000 0.67497 202,491 4 --
300,000 0.59208 177,624 5
-- 300,000 0.51937 155,810 6
-- 300,000 0.45559 136,676 7
-- 300,000 0.39964 119,891 8
-- 300,000 0.35056 105,167 9
-- 300,000 0.30751 92,252 10
-- 300,000 0.26974
80,921 Total inflows 3,000,000 1,564,830 Net
present value 64,830
8
A Capital Project

• _at_ 14
• 1,564,830
• 1,500,000
• 64,830

Inflows 300,000 X 5.2161 Outflow Net present
value
Discounted payback 9th year
Undiscounted payback 5 years
9
Payback or IRR?
Project B 25 2 years
Project A 30 4 years
IRR Payback
10
Projects Yearly Cash Outflow and Inflows
1,5 1,2 ,9 ,6 ,3 0
In 000s
Expected cash inflows
Present value of inflows
Cost of project
1 2 3 4 5 6
7 8 9 10
Present value of expected annual cash inflows
Loss of value due to time
11
Net Present Value and Internal Rate of Return
In 000s
3,000 2,500 2,000 1,500 1,000 500 0 Project cos
t Discount rate Factor Present Value NPV
Inflow Outflow
-1,500 0 1.000 3,000 1,500
12
Quantitative Yardsticks Use
Number of 25 companies using each criteria
Total Degree of emphasis
Major Minor
Accounting rates of return
19
10
9
Payback - Regular - Bailout
25 1
9 --
16 1
Discounted cash flow Internal rate of return
Net present value Net present value index
At least one DCF method
21 14 3 22
20 8 2 21
1 6 1 1
13
Accounting Methods
What they are Also referred to as traditional
yardsticks, the financial statement
method, the accountants method and the
book value rate of return make use of data
presented on financial statements to express
the economic results of a capital project. What
they do They give a rate of return on a capital
project at a particular point in time (year)
based on book profit and book investment. How
they work A. Based on investment 1.
Return on original investment 2. Return
on average investment 3. Return on
depreciated investment B. Based on capital
employed C. Based on average profit D.
Based on equity
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Calculating the Return on Investment
Assets . . . . . . . . . . . . . . . . . . . . .
. . 1, 500,000 Net working capital . . . . .
. . . . . . . 500,000 Total capital
employed . . . . . . . . . . 2,000,000
Profit Year 1 . . . . . . . . . .
. . . . . . . . . . . . . . . . .
50,000 Year 2 . . . . . . . . . . . . . . . . .
. . . . . . . . . . 200,000 Year 3 . . . . .
. . . . . . . . . . . . . . . . . . . . . . .
375,000 Year 4 . . . . . . . . . . . . . . . . .
. . . . . . . . . . . 510,000 Year 5 . . . . .
. . . . . . . . . . . . . . . . . . . . . . .
690,000
15
Calculating the Return on Investment
Assets R D . . . . . . . . . . . . . .
. . . . . . 150,000 Equipment/machinery .
. . . . . . 850,000 Other assets . . . . .
. . . . . . . . . . 500,000 1,500,000
Net working capital 500,000
Total capital employed 2,000,000
Inventory 300.0 Total 900.0
Acc. Pay. 400.0 Net working Capital
500.0
Income after
taxes Year 1 . . . . . . . . . . . . . . . . . .
. . . . . . . . . 50,000 Year 2 . . . . . . .
. . . . . . . . . . . . . . . . . . . .
200,000 Year 3 . . . . . . . . . . . . . . . . .
. . . . . . . . . . 375,000 Year 4 . . . . . .
. . . . . . . . . . . . . . . . . . . . .
510,000 Year 5 . . . . . . . . . . . . . . . . .
. . . . . . . . . . 690,000
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Projected Income Statement and Cash Flows
Years 1 2
3 4 5 Sales Revenue 1,300.0
1,700.0 2,415.0 3,000.0 3,700.0 Cost
of sales 600.0 700.0
990.0 1,240.0 1,560.0 Gross profit
700.0 1,000.0 1,425.0 1,760.0
2,140.0 Selling and admin expenses
350.0 400.0 500.0
600.0 650.0 Income before CCA 350.0
600.0 925.0 1,160.0
1,490.0 CCA 250.0 200.0
175.0 140.0 110.0 Income before taxes
100.0 400.0 750.0
1,020.0 1,380.0 Income taxes (50)
50.0 200.0 375.0 510.0
690.0 Income after taxes 50.0
200.0 375.0 510.0 690.0 Add back
CCA 250.0 200.0
175.0 140.0 110.0 Cash Flow 300.0
400.0 550.0 650.0 800.0
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Projected Cash Flows
Years 0 1 2 3
4 5
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The Payback Period
What it is Also known as the cash recovery
period, the payoff method or the payout
method measures the period of time it takes
for the cash outflow of a project to be totally
recovered by the anticipated cash inflows it
measures how soon the initial funds disbursed
are recovered by the project. What it does It
appraises time risk (not risk conditions or
uncertainties). How it works Years Annual
net cash flows Cumulative cash flows
0 (1,500,000) (1,500,000) 1
50,000 ( 1,450,000) 2 150,000 (
1,300,000) 3 550,000 (
750,000) 4 650,000 ( 100,000)
5 1,600,000 1,500,000
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Net Present Value
What it is Measures the difference between the
sum of all cash inflows discounted at a
pre-determined interest rate (the hurdle
rate), which sometimes reflects the companys
weighted cost of capital, and all cash
outflows. What it does Shows whether or not the
use of borrowed funds for a project has
greater financial merit than the cost of
borrowing. How it works Annual net
10 Years cash flows discount
factors Present value 0 (1,500.0)
1.000 (1,500.0) 1 50.0 0.909
45.4 2 150.0 0.826
123.9 3 550.0 0.751
413.1 4 650.0 0.683
444.0 5 1,600.0 0.621
993.6 2,020.0 Net present value
(NPV) 520.0
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Internal Rate of Return
What it is Also known as the discounted cash
flow, the true yield, or the investors
method can be described as the specific
interest rate used to discount all future cash
inflows, so that their present value equals the
initial cash outflows. What it does Shows the
economic merits of independent projects, and of
mutually exclusive ones, and compares their
returns to other financial indicators, such as
the weighted cost of capital and the companys
weighted rate of return. How it works Years
Cash flows 17 18 19 0 (1,500.0)
(1,500.0) (1,500.0)
(1,500.0) 1 50.0 42.7
42.4 42.0 2 150.0 109.6
107.7 105.9 3 550.0 343.4
334.7 326.4 4 650.0 346.8
335.3 324.1 5 1,600.0 729.8
699.4 670.4 Net present value (NPV) 72.3
19.5 - 31.2
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The Profitability Index
Also known as the present value index, or
benefit-cost ratio, shows the ratio of the
present value of cash inflow to the present value
of the cash outflow, discounted at a
predetermined rate of interest.
What it is
What it does
Helps to rank capital projects by the ratio of
the net present value for each dollar to the cash
outflow and to select the projects with the
highest index until the budget is depleted.
How it works
Present value of cash inflows Cash outflow
2,020.0 1.347 1,500.0
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4. Sensitivity Analysis
What it is Involves the identification of
profitability variations as a result of one or
more changes in the base case regarding
certain key elements of a project, such as the
purchase of land, buildings, equipment, sales
volume, selling price, cost of materials, or
labour and even the length of the economic life
of a project. What it does Gives a range of
results based on patterns of variation on the
use of one single set of factors generating the
best possible results. How it works Factors
variation in factor Internal rate
of return Base case ------
18.4 Selling price -10
14.2 Cost of construction 5
17.3 Sales volume -10 16.6
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Measuring Risk Through Analysis
What it is Process of attaching probabilities to
individual estimates in the base case. What it
does Shows the full spectrum of return outcomes,
from the most pessimistic to the most
optimistic, by weighing the uncertainty
factors. How it works Sales volume (000s
units) 100 200 300 400 Probabilities .05
.15 .65 .15 Selling price () 1.50 1.70 1.90
2.10 Probabilities .05
.15 .70 .10 Cost of labour () .75 .80 .85
.90 Probabilities .05 .15 .65 .15 P
roject cost (000s) 200 250 300 350
Probabilities .05 .10 .75 .10 Life of project
(years) 10 11 12 13
Probabilities .05 .10 .80 .05
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Risk Analysis
Output document would read as follows
IRR range Occurrences of total
cumulative 5-8 4 .4
.4 8-11 30 3.0 3.4 11-14
133 13.3 16.7 14-17 323 32.3
49.0 17-20 283 28.3 77.3 20-23
167 16.7 94.0 23-26 43 4.3
98.3 26-29 17 1.7
100.0 1,000 100.0
Minimum rate of return 5.3 Maximum rate of
return 29.3 Mean 18.1
Probability 68.3 that the return will fall
between 15.6 and 22.0 95.5 that the return
will fall between 9.0 and 23.9 99.7 that the
return will fall between 5.9 and 29.0
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5. Capital Constraints
Cash insufficiency
Not enough cash generated by project to pay for
fixed charges (interest charges)